ErasmusUniversityRotterdam
Faculty of Economics
Department ACCOUNTING, AUDITING & CONTROL
‘Are auditors more alert on fraud?’
ISA 240, NV COS 240, SAS 99
By:
Studentnumber: 283384
Name: : L.L. Roggeveen
Date: September 2009
Supervisor: E. A. de Knecht RA
Co-reader: Dr. sc. ind. A.H. van der Boom
Table of contents
1Introduction
1.1Background
1.2Accruals
1.3Research Question
1.4Demarcation
1.5Methodology
1.6Structure
2Fraud
2.1Introduction
2.2Definition of Fraud
2.3Conditions concerning the use of fraud
2.3.1Incentives / Pressures
2.3.2Opportunities
2.3.3Attitudes / Rationalization
2.4Ways of influencing the financial statements
2.4.1Income smoothing
2.4.2Earnings management
2.4.3Big bath accounting
2.4.4Cookie Jar reserve
2.4.5Other methods
2.5Summary
3Monetary Incentives
3.1Introduction
3.2Agency theory
3.3Positive Accounting Theory
3.4Previous research on the relation between fraud and monetary incentives
3.5Summary
4The International Standards on Auditing
4.1Introduction
4.2The Standard Basis, ISA 240
4.3Responsibility according to ISA 240
4.4In which way based on the content of ISA 240, frauds needs to be detected
4.5Audit conclusion
4.6Statements on Auditing Standards rule 99
4.7Dutch administration of justice
4.8Act on the supervision of audit firms
4.9Summary
5Fraud indication
5.1Introduction
5.2The use of accruals
5.3Methods to measure accruals
5.4Summary
6Hypothesis development
6.1Introduction
6.2Prior research
6.3Hypothesis
6.4Summary
7Research design
7.1Introduction
7.2Research design
7.3Research methodology
7.4Measuring accruals
7.5Control variables
7.6Sample selection
7.7Summary
8Results for empirical tests
8.1Introduction
8.2Test of models
8.3Summary
9Conclusion
9.1Introduction
9.2Summary of results
9.3Conclusion
9.4Limitations
9.5Suggestions for future research
Literature
Appendix A
1Introduction
1.1Background
At the start of the new millennium, a number of fraud cases shocked the economic markets. These cases were spread out over the whole world and were not limited to the United States of America only. One of the well know fraud cases, is about the case of Enron. The Enron Company lost over $70 billion in market capitalization when the fraud was discovered. Public and government were surprised by this happening. The whole story was recently told in a television documentary. The Enron case was not the only case, which was connected to fraud; many others, like WorldCom, Tyco, Ahold and Quest were also accused of fraud during the same period. All these cases had drawn attention from both scientist and public. They started to ask questions like; how could this happen? Why did the auditor not do his job? What made the managers act like this? The governments of various countries also worked on this subject. So did the International Auditing and Assurance Standards Board (IAASB) in their International Standards on Auditing (ISA).
To minimize the risk onfinancial statement fraud, the governments of various countries have introduced a variety of rules. In addition, to limit the risk on the approval of financial statements that contains fraud, the financial auditing bodies in the various countries have introduced statements to limit the risk on the approval of financial statements that contain fraud.Nevertheless,what is fraud and what are the risk factors? What rules do exists for the financial auditor? The difficulty with fraud is that its purpose is to remain hidden and the expectation the public has from the auditor. The public expects from the financial auditor to prevent fraud and to assure that the financial statements are correct. Fraud can cause incorrect financial statements, which could be material. Since the profession of auditing is based on trust, it is essential to minimize such risk and to execute those actions to prevent financial statement fraud. However, the auditor does not control all actions of the company. Managers tend to deceive when they face monetary incentives like large bonuses. This fact, combined with the risk on fraud and the expectations from the public to an auditor it is essential to consider financial statement fraud. However, if the auditor always considers fraud, the fraud cases from the past should not have occurred. It can be concluded that auditors did not act strictly enough on risks for fraudulent financial statements.
In an attempt to improve the auditors focus on fraud, the United States of America introduced in 2002 the Statement on Auditing Standards (SAS) rule number 99; Consideration of Fraud. This statement requires the auditor to execute a number of actions during the audit. The International Auditing and Assurance Standards Board soon followed with an improved version of the ISA 240; the auditor’s responsibility to consider fraud and error in an audit of financial statements.
“The purpose of the International Standard on Auditing (ISA) is to establish basic principles and essential procedures and to provide guidance on the auditor’s responsibility to consider fraud in an audit of financial statements[1] and expand on how the standards and guidance in ISA 315 “Understanding the Entity and its Environment and Assessing the Risk of Material Misstatement” and ISA 330, “The Auditor’s Procedures in Response to Assessed Risks” are to be applied in relation to the risks of material misstatement due to fraud. The standards and guidance in this ISA are intended to be integrated into the overall audit process.” (NIVRA 2005, p. 356)
The Dutch government did also add to this discussion by introducing the law on the supervision of auditing firms. This law in June 2005 by the Dutch government was accepted and concerning auditors contains in relation with fraud a legal responsibility.
It may be clear that in every company there is a risk on fraud. This fact is recognized by both governments and regulating authorities on the area of financial reporting. In addition, this same risk is found in literature approached in different ways. In an attempt to regain the public trust and limit this risk, a number of rules have been changed or added. Of course, the goal of all these changes in rules and regulations is a decrease of fraud in companies.
1.2Accruals
In every system, different ways exist to interpret the rules. In some cases more possibility to act in conformity with the rules as in other cases. These accounting choices are made by a manager and are audited by an auditor. This can create some tension when the auditor does not want the manager to use certain systems; especially changing the system in order to gain different profits can be suspicious. Committing fraud by altering financial statements can be realized in several ways. In general, a manager will use a method that is within the rules and consequently in the first place is legal. Watts (Watts & Ross, 1977) and Zimmerman (Watts, Ross, & Zimmerman, 1978) find that bonus schemes can create incentives for managers to use particular accounting procedures and accruals to increase the present value of their current bonus. Measuring accounting accruals can be a method to measure how strict the rules are applied. The International Standard on Auditing (ISA) added new rules in which the auditor is required to conduct actions to limit the fraud risk. This should influence the (height of) accruals allowed by the auditor.
1.3Research Question
Based on the previous information, a lead exists that auditors are more anxious to detect fraud to comply with the recently introduced ISA and the Dutch Wta (Wet Toezicht Accountantskantoren = Act on the supervision of audit firms). The problem setting of this research will be therefore:
“What is the impact on auditors of the introduction of the International Standards on Auditing in respect on the indication concerning financial statement fraud for firms that use monetary incentives?”
To answer this question, the next sub-questions have been formulated:
-What is fraud? What is the content of the term fraud, and what are reasons to use fraud?
-What is the increased risk of fraud concerning firms using monetary incentives?
-What is the content of the International Standard on Auditing 240 and related standards focusing on decreasing the risk of the use of fraud within companies?
-In which way can fraud be detected? Which indicators are found by previous research?
-What is the responsibility of the public auditor to detect and to communicate fraud and the suspicion of fraud?
1.4Demarcation
The scope of this research limits to companies which have monetary incentives for their top managers and which have a stock exchange listing. In this research will be examined what impact is of the ISA on the financial statements concerning the years before and the years after the introduction of the ISA statements in 2002. Data will range from 2000 to 2007. In the Netherlands, Dutch stock listed firms need to comply with the Dutch laws and regulations. This research uses the changes in these Dutch regulations as a starting point. The data set will be therefore limited to Dutch firms. The data availability from all firms is not available. The stock listed firms are required to publish an annual report. Thus, the data is from Dutch, stock listed firms.
1.5Methodology
In order to obtain a problem setting in which the research can be performed, different leads are needed. First, what is fraud? First, a theoretical definition of fraud will be defined. After this, it will be explained why a legal method of altering financial statements can become fraud in a later stage. This is needed to explain why the focus of the auditor needs not only to be on the actual fraud, but to all signals, which can lead to fraud. In relation to fraud, monetary incentives are introduced to narrow the focus for the auditor. By using theory and papers, the possible relation between fraud and monetary incentives are shown. Next, the International Standards on Auditing are presented, especially the ISA 240 “The auditor’s responsibility to consider fraud and error in an audit of financial statements”. Based on this information concerning the researcha theoretical framework exists. A reason exists to believe that a higher risk on fraud is present, and the auditor has an increased responsibility to detect fraud. The methodology used in this research, is a field study. Data will be collected from before and after the introduction of the International Standards on Auditing and then compared. The accruals are part of the annual report that can be explained by accounting choices. These accruals contain an indication concerning the use of fraud along with some other methods found in literature. In order to detect an indication concerning the use of fraud, in the past several methods have been used. A couple of methods will be tested concerning changes during years. Since the introduction of more severe accounting rules should decrease the possibility of the use of fraud, the indication for fraud is expected to lower during these years.
1.6Structure
The thesis will be structured as following; the subject will be introduced in the first chapter. The second chapter is concerning the content of fraud, what is fraud? What concerning people actually is need to commit fraud. Some fraud risks will be examined in more detail, on which the next chapter will continue.
Chapter three explains the combination of monetary incentives and the risk of the use of fraud. It will explain why monetary incentives create an increasing risk for fraud.
Chapter four will emphasize on the rules for the auditor. It will be about the ISA 240, and NV COS 240, the SAS 99 and the Dutch act on the supervision of auditing firms. In addition, the requirements, which are the result of this new standard, will pass by and why these requirements are influencing the view of an auditor on the result of a company.
Chapter five will focus on indicating fraud. Several ways of detecting fraud is possible. This chapter shows what prior research has used and what the results were.
Chapter six is focusing on in which way to measure and the theoretical expectations. In this chapter, by using information in the previous chapters and results on fraud research by previous research the hypotheses will be formulated.
In chapter seven, the research design is explained. In this chapter, the way of measuring fraud indication in this study is explained. In addition, the data set is named.
The results of the empirical tests are shown in chapter 8.
The last chapter, chapter nine, concludes the previous chapters and gives the conclusion of the empirical research. The chapter will address weaknesses in this research and contain recommendations for the reader for future research.
2Fraud
2.1Introduction
Every time a new ‘mistake’ is discovered in the annual reports of companies, people immediately think of fraud. If the annual report needs to be corrected, the stock prices of that company fall down massively and need a long time to recover. A very large recent fraud case is the Enron case. Enron was a utility company, which provided cities with electricity; this electricity was generated by some power plants of Enron.
The Enron fraud has already been started in the nineties of the last century but was not detected until 2001. After the fraud was discovered, the value of a share dropped from $90 a piece to $0,50. The auditing firm involved in the Enron story was Arthur Andersen, which in the aftermath of the scandal went down with Enron. What did Enron do? In addition, what did Arthur Andersen not do to prevent this fraud and caused the end for the auditing firm? Enron’s profit was the result of deals with special purpose entities, which were controlled by Enron but not included in the annual reports. These profits drove the stock price to high levels, and the executives began to work with insider information to trade Enron stock. Jeffrey Skinning, the chief executive of Enron, sold at minimum 450,000 shares of Enron and gained around $33 million for this.[2] He left the company just after six months for a ‘significant’ reason. On October 22, 2001, the Securities and Exchange Commission announced its investigation in several suspicious deals by Enron, pronouncing “some of the most opaque transactions with insiders ever seen”.[3] The auditing firm, Arthur Andersen was also accused. The allegations against Arthur Andersen included charges of obstruction of justice related to Enron. Arthur Andersen shredded documents related to the audit of Enron. The United States Securities and Exchange Commission does not allow convicted felons to audit stock listed companies. This was the end of Arthur Andersen as one of the Big Five firms. Nowadays, only four of them are still doing business.
Despite efforts of auditors, the Enron fraud was not the only one, which caught a lot of attention. In the Netherlands, the Royal Dutch Ahold Company became news in relation to a bookkeeping scandal. The Ahold case rests in two parts, one part are the side letters that the management received in respect to the consolidation of an entity in which Ahold participated. The second part was about discounts Ahold received. Ahold recorded the discounts as profits before the discounts where actually received. Aholds top executives and auditor have been sued for the financial damage to investors after the fraud was discovered.
“Amsterdam, 22 February. Auditing firm Deloitte and four former Ahold executives are sued by the Company Information Foundation. The foundation holds Deloitte and the executives responsible for the financial statement fraud and the financial damage stockholders faced. Representing about 500 traders, the foundation claims millions of euros of Deloitte and the executives.”[4]
The foundation accuses Ahold and Deloitte of presenting misleading information about the financial position of Ahold. The fraud covered an amount of 800 million euro’s, mainly caused by the US Foodservice entity, which Ahold controlled in 2003.
These are just two examples, many more can be found in the recent history. In almost all the examples, the stockholders are the ones who lose the most money. The stock prices of companies in which fraud has been detected generally plumed down significantly. This shows how important it is, that an auditor considers and limits the risk of fraud. Nevertheless, what is fraud? What is needed for people to commit fraud? In the next paragraph, the content of the term fraud will be defined.
2.2Definition of Fraud
The term fraud, as a legal concept, describes any intentional deceit meant to deprive another person or party of their property or rights. (Arens et al. 2008, p. 338) This definition means that all intentional deceiving of other people belongs to the term fraud. Especially, the intention is what makes fraud, fraud. When no intention exists, it can be either an error or something, which in advance is not foreseen. The definition in the context of auditing financial statements, fraud is defined as an intentional misstatement of financial statements. (Arens et al. 2008, p. 338)
Fraudulent financial reporting is an intentional misstatement or omission of amounts or disclosures with the intent to deceive users. (Arens et al. 2008, p. 338) Again, the word intentional makes fraud different from errors. Because expenses were capitalized while it should have been reported as expenses, in the WorldCom fraud, for example, the reported fixed assets were incorrect. Omissions of amounts do not occur as often as an intentional misstatement, but companies might overstate income by omitting accounts payable.
To create a reserve for the future, companies might lower their current income, also called “a cookie jar reserve”. Other practices are earnings management, which involves actions to either increase or decrease current reported income, and income smoothing, which results in a more constant income over time.